“Bad Banks” for Beginners

For a complete list of Beginners articles, see the Financial Crisis for Beginners page.

What is a bad bank? . . . No, I don’t mean that kind of bad bank, with which we are all much too familiar. I mean the kind of “bad bank” that is being discussed as a possible solution to the problems in our banking sector.

In this sense, a bad bank is a bank that holds bad, or “toxic” assets, allowing some other bank to get rid of these assets and thereby become a “good bank.”

To understand this, you need to understand what a bank balance sheet looks like. I’ve covered this elsewhere, but for now a simple example should do. Let’s say that the Bank of Middle-Earth has $105 in assets (mortgages, commercial loans, cash, etc.), $95 in liabilities (deposit accounts, bonds issued, other financing), and therefore $10 in capital. The assets are things that have value and theoretically could be sold to raise cash; the liabilities are promises to pay money to other people; and the capital, or the difference between the two, is therefore the net amount of value that is “owned” by the common shareholders. Next assume that the assets fall into two categories: there are $60 of “good” assets, such as loans that are still worth what they were when they were made (no defaults and no increased probability of default) and $45 of “bad” assets, such as loans that are delinquent, or mortgage-backed securities where the underlying loans are delinquent, etc. Say the bank takes a $5 writedown on these bad assets, so it now counts them as $40 of assets, but if it actually had to sell them right now they would only sell for $20 because no one wants to buy them.  (When a bank has to take a writedown and for how much is a complicated subject; suffice it to say that in many cases banks have assets on their balance sheet at values that everyone knows could not be realized in the current market, and this is completely legal.)

Right now the bank balance sheet has $100 in assets, $95 in liabilities, and $5 in capital, so it is still solvent. However, everyone looking at the bank thinks that those $40 in bad assets are really only worth $20, and is afraid that the bank may need to take another $20 writedown in the future. So no one wants to buy the stock and, more importantly, no one wants to lend it money, because a $20 writedown would make the bank insolvent, it could go bankrupt, stockholders would get nothing, and creditors (lenders to the bank) would not get all their money back. Because no one wants to lend it money, the bank itself hoards cash and doesn’t lend to people who need money.

Although not necessarily to scale, this is roughly what the banking systems of the U.S. and several other major economies look like right now.

How does a bad bank solve this problem? There are two basic models: one in which each sick bank splits into a good bank and a bad bank, the other in which the government creates one big bad bank and multiple sick banks unload their toxic assets onto it.

Bank mitosis

In the first model, the Bank of Middle-Earth splits into two: a Bank of Gandalf and a Bank of Sauron. The Bank of Gandalf gets the $60 in good assets, and the Bank of Sauron gets the $40 in bad assets (that may only be worth $20). The Bank of Sauron will probably fail. But the Bank of Gandalf no longer has any bad assets, so people will invest in it and lend money to it, and it will start lending again.

This model has one tricky problem, though: How do you allocate the liabilities of the old bank between the two new banks? Luigi Zingales says the simplest solution is to do it on a proportional basis. Because the Bank of Gandalf gets 60% of the assets, it gets 60% of the liabilities. So if the Bank of Middle-Earth owed someone $1, now the Bank of Gandalf owes him 60 cents and the Bank of Sauron owes him 40 cents. Now the Bank of Gandalf has $60 in assets, $57 in liabilities (60% of $95), and $3 in capital; the Bank of Sauron has $40 in bad assets (that are really only worth $20) and $38 in liabilities. Instead of one sick bank with $100 in assets that isn’t doing any lending, you have a healthy bank with $60 of assets that is lending, and what Zingales calls a “closed-end fund holding the toxic assets” whose creditors will probably get some but not all of their money back. The tricky part is that this is a good deal for shareholders in the Bank of Middle-Earth and a bad deal for creditors to the Bank of Middle-Earth, and so it’s illegal for banks to divide up the liabilities like this. Zingales recommends legislation to make it possible, but I suspect that even were Congress to pass such a bill, there would still be lots of lawsuits challenging its constitutionality.

I started with Zingales’s version of bank mitosis because it illustrates the principle neatly, but the legal complication makes it difficult to implement in practice. Another way to divide one back into two is to find separate funding for the Bank of Sauron. This is what UBS did in November, with the support of the Swiss government. UBS had $60 billion in bad assets that it unloaded onto the new bad bank. To pay for those bad assets, however, the bad bank needed $60 billion. How did it get it? First UBS raised $6 billion in new capital by selling shares to the Swiss government. Then it invested those $6 billion in the bad bank – that became the bad bank’s capital. Then the Swiss central bank loaned the bad bank $54 billion. (There is little chance that any private-sector entity would lend a self-confessed bad bank money, but this was in the public interest.) Because shareholders get wiped out first, that effectively means that UBS was taking the first $6 billion in losses, and any losses after that would be borne by the Swiss government. This constitutes a subsidy by the Swiss government to UBS, but one that was justified by the need to stabilize the financial system. At the end of the transaction, UBS had diluted its shareholders by 9% (because of the new shares sold to the government) and had a $6 billion investment in the bad bank it was likely to lose, but it had cleaned its balance sheet of $60 billion in toxic assets.

One issue in this version is how to value the assets that are being sold to the bad bank. If they are sold at market value ($20 in the Middle-Earth example), then the parent bank has to take a writedown immediately, which arguably defeats the purpose of the whole transaction (because that could render the parent bank immediately insolvent). In that case, the parent bank would need to be recapitalized (presumably by the government) immediately, and the “bad bank” would actually be not that bad, since it is holding assets it bought on the cheap. If they are sold at the value at which they are carried on the parent bank’s balance sheet, then the bad bank is essentially making a stupid purchase (overpaying for securities it expects to decline in value) for the public good. In the UBS case, forcing UBS to provide the $6 billion in capital was a way of forcing UBS to suffer at least some of the loss that the bad bank was expected to incur.

Big Bad Bank

The second model, which has been proposed by Sheila Bair, Ben Bernanke, and others, is the “aggregator” bank. Instead of splitting every sick back into a good bank and a bad bank, in this model the government creates one Big Bad Bank, which then takes bad assets off the balance sheets of many banks. (This doesn’t necessarily have to be created by the government; the Master Liquidity Enhancement Conduit – bonus points for anyone who remembers what it was for – was supposed to be funded by private-sector banks. But in today’s market conditions, the government is the only plausible solution.) In this plan, the capital for the Big Bad Bank is provided by the Treasury Department (perhaps out of TARP), and the loan comes from the Federal Reserve, which has virtually unlimited powers to lend money in a financial emergency. Once this Big Bad Bank is set up and funded, it will buy toxic assets from regular banks, which will hopefully remove the uncertainty that has hampered their operations.

Yes, the Big Bad Bank is similar in concept to the original TARP proposal, and it faces the same central question: what price will it pay for the assets (the issue discussed two paragraphs above)? If it pays market value, it could force the banks into immediate insolvency, so recapitalization would have to be part of the same transaction. If it pays current book value (the value on the banks’ balance sheets), it will be making a huge gift to the banks’ shareholders. There has been talk of forcing participating banks to take equity in the Big Bad Bank (as in the UBS deal), presumably to make them shoulder some of the overpayment. In any case, the money the government puts in, up to the market value of the assets purchased, is a reasonable investment for the taxpayer; but there will need to be additional money, either to recapitalize the remaining banks (which, if done at market prices, would lead to government majority ownership), or to overpay for their assets. Pick one.

One last issue: Creating a bad bank works nicely if you can draw a clear line between the good assets and the bad assets. My theoretical Bank of Gandalf above only has good assets, so there are no doubts about its health. But what if you can’t? This crisis started in subprime mortgage-backed securities, and it’s pretty clear that things like second-order CDOs based on subprime debt are deeply troubled. But as the recession deepens, all sorts of asset-backed securities – such as those backed by credit card debt or auto loans – start losing value, and then even simple loan portfolios lose value as ordinary households and businesses that were creditworthy just a few years ago go into default. Put another way, if it were possible to neatly separate off the bad assets, then the second Citigroup bailout would have worked, since that provided a government guarantee for $300 billion in assets. Yet Citigroup’s stock price, even after Wednesday’s huge rally (up 31%) is still below the price on November 21, the last trading day before that bailout was announced. Clearly no one believes that Citigroup had only $300 billion in bad assets.

The goal of a bad bank is to restore confidence in the good bank, and it’s not clear how much of the parent bank’s assets have to be jettisoned before anyone will have confidence that only good assets are left. One potential problem with the Big Bad Bank is that banks could be tempted to underplay their problems, sell only some of their bad assets, hope the rest are all good, take the bump in their stock price . . . and then show up two quarters later with more bad assets. If investors suspect that is going on, and that the banks are still holding onto bad assets, then the scheme will fail. The solution to that problem is to overpay for the assets, which gives banks the incentive to dump all of them onto the Big Bad Bank . . . and then we are back where we started.

Update: Citigroup’s division into a good bank (Citicorp) and a bad bank (Citi Holdings, which includes the $300 billion in assets guaranteed by you and me) is more symbolic than anything else at this point, because they are still just divisions of one company. So if Citi Holdings goes broke, the creditors can demand money from Citicorp, which defeats the purpose of a good/bad separation. The goal here was more to communicate what the bank’s long-term strategy is (the hope is to either sell off or run off everything in Citi Holdings) in hopes of convincing shareholders that the management knows what they are doing.

18 responses to ““Bad Banks” for Beginners

  1. So what is wrong with my (naive) proposal, which is to use taxpayer money to create one or more new GOOD banks, have the new banks buy the GOOD assets from the current bad banks at distressed prices, and let the bad banks fail?

    In short, why are taxpayers bailing out this industry? Why are shareholders, bondholders, and counterparties not taking the first hit for the risks they voluntarily took on?

    Simply put, don’t we already have enough bad banks?

  2. Dear Mr. Nemo,

    Could you please explain who is going to capitalize the new GOOD banks that you want to create in today’s environment?

    And if you were the CEO of a distressed bank, would you be willing to sell your good assets to the GOOD bank just so your company could go belly up? Would you furthermore be willing to sell them at distressed prices or instead want to demand a very high price and increase the chances of your company’s survival?

    Are your good banks going to be public companies? If so, who in the world is going to be willing to buy shares in your good banks when shareholders are getting wiped out across the board from bad banks going under? If all kinds of major banks are allowed to go under, will anybody be willing to ever invest in a bank again?

    Seems you would like to really stick it to shareholders, bondholders and counterparties (actually managers are the ones who have really screwed up). But you need shareholders, bondholders, and counterparties to make the system work. When you destroy their confidence in the system, you get what we have right now.

  3. This video also helps easier understanding of what you have just mentioned.

    http://marketplace.publicradio.org/videos/whiteboard/bad_banks.shtml

    cheers.

  4. Many people seem to think that there are hundreds of banks out there that are effectively insolvent.

    According to FDIC Chairwoman Sheila Bair (and she should know), this is far from the truth. In an interview on CNBC today she stated,

    “I think it needs to be emphasized and re-emphasized these banks are solvent, they’re well-capitalized overwhelmingly, and that really is what creditors and depositors seem to be focusing on right now.”

    See http://finance.yahoo.com/news/Nations-Banks-Are-cnbc-14116000.html.

    The problem of course is that, with the recession continuing to erode revenues and employment, the situation could be drastically different in 6 months.

    Now imagine we could take a distressed bank, say Citigroup, and shift it with its current assets ahead in time to the middle of 2010. It is quite likely at that time that the economy will be in full recovery mode, the future will look rosey, and Citi’s toxic assets will have recovered somewhat from their erosion (unemployment is going down, government loan modifications are reducing foreclosures, etc). Even if those toxic assets end up being drastically devalued, Citi will likely have generated the required revenue in the intervening time to make up for losses.

    The problem, therefore, for Citi and other banks is not the long run, but making it through the near term without going bankrupt. This is why removing the toxic assets right now from the balance sheets can be so effective. It provides the cushion they need to survive the near term.

    This is also the reason why I advocated in another comment (under “Nationalization Is Not Inevitable”) that the final purchase value of toxic assets by the government-sponsored AGGREGATOR BANK be delayed for a period of time. A more realistic appraisal of the assets can be established in the future and the banks will be more capable of making up any losses generated by liquidation of the assets in the future.

    A lot of the banks that appear to be under stress are very powerful revenue and income generators. The function they serve in the economy is obviously vital and the wealth they can generate for the economy is substantial. It simply does not make sense to allow these firms to go under and try to start over again. Better to fire the managers and hire new ones.

    I believe the AGGREGATOR BANK concept can really work because it will get the banks through the dangers of the near term. And if it is implemented correctly, I believe everybody, including the tax payer, will come out ahead.

    What more could you ask for?

  5. Tom,

    I completely disagree with everything you say. What a joke this “bad bank” idea is.

  6. Tom K —

    “Could you please explain who is going to capitalize the new GOOD banks that you want to create in today’s environment?”

    Certainly. The U.S. taxpayer. Instead of rewarding the existing failed institutions for their failures, we simply replace them. Saving the system does not mean saving the existing firms.

    “And if you were the CEO of a distressed bank, would you be willing to sell your good assets to the GOOD bank just so your company could go belly up?”

    Oh, that would happen automatically as your company entered liquidation. The taxpayer-owned new bank would get an excellent deal for your assets, which is the point.

    “Seems you would like to really stick it to shareholders, bondholders and counterparties (actually managers are the ones who have really screwed up).”

    Shareholders, bondholders, and counterparties voluntarily took on the risk of doing business with those managers. (If they have a problem, by all means, they can go after the managers.)

    As a taxpayer, I still do not see why this is MY problem.

    Look, the losses have already happened. All we are doing now is deciding who is going to pay for them. I fail to see why that should be anyone other than those who took on the risk hoping to profit.

    If my company screws up to the point where its liabilities exceed its assets, it enters bankruptcy. Let Citigroup do the same; stop confiscating my wealth to reward failure in proportion to the size of the failure.

  7. Dear Mr. Nemo,

    Sounds great! Let thousands (millions?) of creditors and investors at a number of major banks get wiped out because of the idiocy of a few executives.

    Won’t be long and we will be where we were in September: a crisis of confidence, the financial system frozen up, and the economy dropping into a deflationary spiral.

    By the way, it won’t be long before your GOOD banks turn into BAD ones. So much for saving your precious tax dollars.

    You may be fond of standing in bread lines. I’m not.

  8. Tom K —

    We already have a crisis of confidence. The only reason Citigroup and BofA can issue debt today is that it is guaranteed by the FDIC. The only reason anyone accepts them as a counterparty is that they are implicitly backed by the U.S. Government. Heck, the only reason they still have DEPOSITORS is that the accounts are FDIC insured.

    Since the only things these institutions bring to the table today is the guarantee from the U.S. taxpayers, it seems to me the taxpayers ought to be the only ones benefiting. So use taxpayer money to capitalize new institutions, and let the old ones fail like they are obviously trying to do.

    As a taxpayer, I can say with certainty that this would help restore my confidence in the system. Or we can continue confiscating my money and giving it to these clowns to pay themselves bonuses and dividends. That works, too.

  9. If being able to “draw a clear line between the good assets and the bad assets” is a prerequisite for a good bank/bad bank solution then this discussion is purely hypothetical.

  10. housam jarrar

    I just find the concept of using even more borrowed taxpayer money to over-pay for toxic assets to be abhoring.Handing out a big gift to the banking industry for their greed and irresponsibilty is not the answer nor will it restore confidence.Confidence is something you earn and from the look of it,I do not see anything inspiring about john thains lavish 1.25 million dollar office remodeling job while people are losing their jobs at his very own firm,or from lewis’s sneaking behind the back of his shareholders to beg the government for some cheap money.I agree with mark farber that the reason we are in this mess is because from the saving & loans crises were no one was allowed to fail a sense of complacensy emerged where banks felt they can do no wrong and if it were to ever happen then uncle sam will foot the bill.

  11. and after that we can nationalize the bad banks… especially if its just 1 bank

  12. Nemo,

    “Instead of rewarding the existing failed institutions for their failures, we simply replace them.”

    Regardless of other issues with that plan, it’s a lot easier to say it than it is to actually create from scratch a number of multi-billion dollar banks. You’re talking about institutions consisting of thousands of people organized and working together, built up over years.

    You could probably create something like that, given access to enough cash, but even assuming an all-star management team you’re talking about a process that would take on the order of half a year to create, and then it would probably be pretty inefficient.

    This is the same reason the government can’t ‘just buy all the toxic mortgage-backed securities, unpackage them, rewrite the terms on the at-risk loans, and then resell them as good assets’. Something like that takes /enormous/ administrative manpower that we just don’t have.

    It’s like suggesting all the people on the Titanic ‘just’ use the materials on board to make more lifeboats. Even if there are enough people to train workers with the necessary skills and if there is enough raw material available to use, it takes significant time to interview people, organize them, get them trained and to actually do the work. By then even the band has given up.

  13. Commode on legs

    Could someone discuss the relevance (or not) of the S&L crisis and the RTC?

    I picked up Greenspan’s memoir yesterday at the library and looked up his comments on the Japanese experience. In 2000, “I suggested that the US government strategy of (1) bankrupting a large part of our failed thrift industry, (2) placing its assets in a liquidation vehicle, and (3) unloading the assets at large discounts in a manner that would reliquify the… market fit the Japanese situation rather closely.” p.290

    Greenspan goes on to state, “The Japanese had purposely accepted hugely expensive economic stagnation to avoid a massive loss of face for many companies and individuals. I cannot imagine US economic policy following such a track.”

    He claims a cultural norm (avoiding loss of face) as the reason for inadequate policy response. Might the US have a cultural norm (avoiding “socialism” in this case bank nationalization) that is producing similar results?

    BTW the Japanese are terrific at playing with outsiders’ stereotypes of Japan. Rather than thinking of “saving face” we should think of “preserving the powers that be.” They muddled through without experiencing high unemployment, maintained their system of single-party “democratic” politics, and the LDP still holds power. This example is unlikely to be overlooked by the Chinese Communist Party.

  14. I like Nemo’s plan. Nemo is right. Tom K is not.

    This should be a great time to start a new bank, with private or public startup funds. NEWBANK would be unencumbered with bad debt. That would give it more flexibility, and of course the ability lend, which toxic banks do not have, and the economy needs.

    Toxic banks may need to sell good assets in order to raise capital to cover writedowns. NEWBANK would be able to be a buyer if it wanted to, at market prices.

    And yes, the existing banks are left to meet their fate. They and their shareholders will reap whatever they sowed.

  15. The other comment I have is that the prudent should be the ones leading us out of this recession.

    Making massive allocations to failing companies is effectively the opposite. Today, prudent people and companies have cash in the bank (mattress).

    Instead of having the government borrow and put $2T into rescue for the imprudent, it should let inflated asset values drop to market value (or lower). Then prudent investors will come out with their cash and invest their own private $2T where it belongs. They will take power and they will be the leaders of the recovery.

  16. Nemo –

    Could you explain why any of the existing banks would sell their good assets to the new, “good” bank? They simply wouldn’t. The only way that this new “good” bank would get the non-toxic assets of the current banks is if the federal government stopped propping up the existing banks, which would lead to toxic assets and their resulting write-downs bleeding out the capital of existing banks, making them insolvent (and therefore forcing them into liquidation), at which point the new “good” bank could acquire the good assets of the existing banks.

    Unless you have another method in mind for transferring the good assets, your proposed solution to saving our financial system is to to just let it crash so a newly capitalized bank can acquire the good assets (which, by the way, wouldn’t be quite that “good” anymore because the whole financial system would have collapsed) of the existing banks?

    Also, considering that the creditors and shareholders getting wiped out by the failure of the existing banks would be a substantial chunk of relatively healthy corporate and individual creditors/investors, your plan would sign the death warrant of the entire economy.

    Apparantly I’m missing a part of your simplistic and genius plan. Could you clarify your solution?

  17. Charles R. Williams

    “This model has one tricky problem, though: How do you allocate the liabilities of the old bank between the two new banks?”

    Simple: assign the equity to the bad bank. Convert the subordinated debt in the good bank into equity in the good bank in an amount sufficient to leave the good bank well capitalized.

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